Staying Focused On Long-Term Investment Goals: The Institutional Approach
By Wilshire Funds Management, sub-adivsor of the AdvisorShares Wilshire Buyback ETF (NYSE Arca: TTFS)
Wilshire Funds Management annually examines the investment returns and relative performance of retail investors as compared to their institutional investor counterparts. Although capital markets present similar levels of uncertainty to all participants, institutions have consistently outperformed retail investors over various time periods, as illustrated in Exhibit 1, below. This paper will review trends within retail investing in an effort to better understand certain dynamics that drive investor decision making. We will also examine the institutional approach to investment management, with the goal of identifying investment characteristics retail investors might consider adopting.
Retail Asset Flows
Evaluating the flow of funds to and from specific asset classes has proven useful when striving to understand the tendencies of retail investors. Exhibit 2 charts the net flow of capital in and out of U.S. mutual funds against the growth of a hypothetical $10,000 investment in the Wilshire 5000 IndexSM, an index which measures the performance of all U.S. securities with readily available price data, from January 2008 to October 2016. Mutual fund flows are useful in tracking the asset allocation decisions of individual investors, as institutions often invest through separate accounts. Net flows trend directionally based on investor sentiment and portfolio positioning, with flows generally gravitating towards riskier assets, like equities and high yield fixed income, in times of economic and corporate growth. During times of distress, flows tend to flee to safer assets, such as U.S. Treasury bonds or money market funds.
Since the bottom of the financial crash in March 2009, the market has entered one of the longest bull runs in history, as depicted in Exhibit 2, with the value of a $10,000 investment on February 2009 more than tripling over the ensuing seven-year period. In the same period, equity flows have remained consistently negative, while bond flows have remained mostly positive as retail investors chose safety over potentially higher returns. Additionally, the variability of capital movement in and out of mutual funds, known as the volatility of fund flows1 and attributable in part to market timing efforts, has also continued to increase post-2008. Even minor market dips are often followed by significant outflows from both equity and bond mutual funds. For example, from July through September 2015, as oil prices plummeted and fears of China’s stagnating economy grew, investors panicked over market uncertainty and pulled out of the market, causing them to miss out on a 13% gain if they had held steady until December 2016.
DALBAR’s Guess Right Ratio
Amidst the ever changing market backdrop, have retail investors allocated capital at the most opportune times? Exhibit 3 charts DALBAR’s Guess Right Ratio, which depicts the frequency with which investors “guess right” in their attempts to time the market. In general, when the Guess Right Ratio exceeds 50 percent, investors have made money from their allocation decisions2. While retail investors were able to “guess right” in 9 of the 12 months in 2015, the average retail investor – including asset allocation, equity and fixed income investors – was still unable to outperform either the U.S. stock or bond market. In 2015, the average retail equity fund investor’s annual performance was -2.28%, lagging the 0.67% return of the Wilshire 5000 Total Market Index by nearly three percent.
Comparing the Performance of Individual and Institutional Investors
A wealth of data suggests that individual investors should take their cues from their institutional counterparts and remain committed to their long-term strategic asset allocation. Emotional and reactionary investment decisions can be damaging to long-term performance and may also trigger negative tax consequences. Exhibit 4 depicts the performance penalty paid by individual investors making emotional investment decisions.
For the 20-year period ending December 31, 2015, the average stock fund returned 8.20% annually while the average stock fund investor returned only 4.70%. Attempting to time the market penalized the average stock fund investor to the tune of 3.50% per year, nearly half of the return they would have achieved had they remained invested. Although this penalty gap has modestly decreased from the year prior, down from 4.66% in the 20-year period ending December 31, 2014, the disparity remains wide. Unlike many individual investors, institutional investors adhere to a structured investment policy to provide a framework for their decision-making process and to curtail the potential for emotional investing. For example, in 2009 many individual investors succumbed to fear and exited the equity market while institutional investors remained committed to their asset allocation policy. By not deviating from policy, institutional investors were able to recover more quickly than individual investors who pulled out of the market altogether.3
Remaining committed to an investment policy is not synonymous with setting and forgetting your portfolio. Exhibit 5 illustrates the asset allocation shifts that foundations and endowments over $1 billion made from 1996 to 2016. Regular rebalancing based on long-term objectives and capital market assumptions is consistent with the best practices of successful institutional investors. It is in large part by exiting the market and attempting to guess the most opportune time to re-enter that individual investors jeopardize their ability of investors to achieve their investment goals.
There are a number of advantages that contribute to institutional investors’ consistently better performance relative to their retail peers. In addition to the meaningful benefits of lower fees and access to certain asset classes like private equity and hedge funds that are cost-prohibitive for many retail investors, institutional investors adopt a longer-term mindset, digesting poor earnings, market corrections and economic shocks as a normal part of market activity. Conversely, many individual investors monitor their portfolios on a daily basis, often making impulsive investment decisions in the face of short-term market dislocations. Further, the practicality of managing large amounts of money involves adherence to firm policy targets, naturally enforcing more disciplined investing. Institutions are innately long-term oriented, allocating capital based primarily on set targets rather than fleeting short-term trends.
These key characteristics and constraints have proven to benefit institutional performance over time, and the continued outperformance of institutional investors supports our thesis that a thoughtfully diversified asset allocation policy has the highest likelihood of maximizing risk-adjusted returns over a full market cycle. No one has certainty as to what the market will deliver, making timing the market virtually impossible, and retail investors must work harder to overcome behavioral biases which have been shown to impede optimal decision making. Staying focused on long-term goals, diligently monitoring risks and exposures, and broadly investing with an institutional mindset is a time-tested approach that has been shown to produce better outcomes.
1 As defined by the Center for Research in Security Prices (CRSP), stating flow vola-tility is equal to the standard deviation of flows over the prior 12 months, divided by the mean flows over the same period.
2 Quantitative Analysis of Investor Behavior – Adviser Edition. Boston: DALBAR, 2015.
3 Investment Company Fact Book 2010. Rep. Investment Compa-ny Institute, http://www.ici.org/pdf/2010_factbook.pdf.